Perspective

Gauthier Vincent

Right-Side Strategies
in Financial Services
Revisiting the
Balance Sheet

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EXECUTIVE
SUMMARY

The credit crisis has exposed a number of shortcomings and

vulnerabilities in the financial services industry. One involves
the long-neglected idea that the right side of the balance sheet
matters. For a number of years, many financial services firms
ignored the importance of right-side strategies, including
funding and capital strategies, but in truth they are absolutely
critical to the long-term success of a financial franchise. In fact,
they are as important as left-side, asset growth strategies.
The funding of asset growth with a core of stable client
liabilities does not just happen. It is most often the result
of both deliberate portfolio choices at the corporate level
and client-centric, integrated asset and liability strategies at
the business unit level. Similarly, capital strategies must be
purposeful, focusing on economic capitalthat is, how much
long-term capital is required to protect shareholders, rather
than merely optimize the use and cost of regulatory capital.

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REVIVAL OF
THE RIGHT SIDE

The recent financial collapse and

meltdown of financial stocks
unmasked a truth that too many
management teams at banks and
financial companies had lost sight of:
Both sides of the balance sheet matter.
Sustainable shareholder value creation
has as much to do with funding and
capital (right-side) strategies as with
asset growth (left-side) strategies.
Consider the events of late 2007
through much of 2008: A sharp
devaluation of mortgage-related
and other financial assets on banks
balance sheets led to a sudden
drying up of funding sources such as
interbank lending and debt issuances.
In turn, the share prices of banks and
financial companies tumbled. Within
months some Wall Street mainstays,
such as Lehman Brothers and Bear
Stearns, were out of business; others,
like AIG and Citigroup, were bailed
out by the U.S. government or, like
CIT, forced into bankruptcy.

Yet, in the midst of all these failures,

some financial companies endured.
The difference between the survivors
and the losers came down to the
strength of their balance sheets
not just the credit quality of their
loan assets and securities on the left
side but also, and more important,
their mix of client deposits and
other liabilities on the right side, the
stability of these liabilities, and the
depth of their capital reserves.
For much of the previous decade,
diversified financial institutions had
often emphasized asset growth to
the detriment of the right side of the
balance sheet. Citigroup is an apt
illustration. By the time the crisis hit,
the company had acquired asset-rich
consumer finance businesses, stocked
up on corporate loans, and greatly
expanded the reach of its trading
operations. As a result, in 2008,
Citigroup found itself structurally
underfunded in core client liabilities.

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It soon started to hemorrhage even the

retail and commercial deposits that it
had. Furthermore, many of the tactics
that the firm, like most other large
financial companies, had used to lower
its capital requirements, including
off-balance-sheet vehicles, had proven
illusory. The government had to step
in quickly, guarantee the companys
deposits, and bring in freshcapital.
The lesson? Right-side strategies
matter. And had financial institutions
not forgotten that, they would have

avoided much of the damage done

to their businesses, their investors,
and their customers. In fact, funding
and capital considerations must be
central to the enterprises strategy.
These activities cannot simply be
delegated to the chief financial officer
anymore but should be squarely on
the CEOs agenda. As this report will
show, financial companies that have
fared relatively well through this
crisis exemplify the way boards and
management teams can develop rightside strategies that create long-term

shareholder value. These stories teach

the following lessons:
An advantaged funding position is
often the result of both corporate
portfolio strategy and business unit
strategy, not just corporate strategy.
Capital strategies must emphasize
growth in economic capital
and regulatory capital, not just
regulatory capital.

Funding and capital considerations

cannot simply be delegated to the chief
financial officer anymore but should be
squarely on the CEOs agenda.

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FUNDING
AS CORPORATE
PORTFOLIO
STRATEGY

Through the 1990s, Capital One

aggressively grew its base of credit
card assets on the back of superior
credit and segmentation capabilities.
By the early 2000s, the company
was leveraging these capabilities
across new asset classes such as auto
loans. Capital Ones funding strategy
was simple: Rely primarily on bond
issuances through capital markets to
match its asset growth.
But in 2003, Capital Ones strategy
came under attack as concerns
suddenly surfaced about the credit
quality of its assets. Almost overnight
the company faced resistance to
rolling over its debt in capital markets.
Its share price fell abruptly by nearly
50 percent as many investors feared
that the company could not survive
much longer as a stand-alone entity.
It turned out that this near-death
experience, several years ahead of the
credit and funding crisis of 200709,
was a blessing in disguise. It forced
Capital Ones senior management to
view funding as a critical element of
enterprise strategy. In the wake of this
reappraisal, Capital One acquired
two retail banks: Hibernia and North
Fork (in 2005 and 2006, respectively).
The company sought these deals to
change its mix of liabilities and to
back its credit card assets with a core
of relatively stable retail deposits.

Although the value of operating cost

savings did not justify the acquisition
premium paid by Capital One, capital
markets reacted positively to the
transactions. Specifically, the deals
substantially reduced Capital Ones
funding risk, which investors had
priced as a premium of 150 to 200
basis points on the companys cost
ofequity.
Just a few years earlier, few would
have thought that Capital One
could withstand a credit crisis of the
magnitude of the current collapse.
Yet not only has the company held its
own throughout this difficult period,
but in the last two years its share price
has outperformed the financial sector
index by 20 percent.
Capital Ones experience illustrates
that funding considerations must be
front and center on the corporate
strategy agenda. Relying on wholesale
markets and brokered deposits for
funding is no longer a solution for
many consumer or commercial
banking businesses. Instead, accessing
low-cost, stable funding, such as retail
or commercial deposits or even pools
of insurance premiums, is essential
to the long-term viability of these
firms. Corporate portfolio strategies
must strike the appropriate balance
between client asset rich and client
liability rich businesses.

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FUNDING
AS BUSINESS
UNIT STRATEGY

At large, diversified financial companies, funding need not only be a

corporate concern. Integrated asset
and liability strategies at the business
unit level can go a long way toward
addressing a companys long-term
funding needs.
Silicon Valley Bank, a midsized commercial banking firm with roots in
Silicon Valley and operations on the
West Coast and in the northeast U.S.,
is a good example. Most of the banks
asset growth in the last five to 10
years has come from venture capital
clients. Working with these entrepreneurs, the bank discovered that
the venture capitalists were often at
two distinctly different points in their
funding cycles: Some had credit needs,
while others were flush with liquidity.
Recognizing the opportunity, Silicon
Valley Bank implemented a clientcentric strategy approach to serving
venture capital clients, striving to
meet their needs on both sides of their

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balance sheets. Thus, the banks

loans to venture capital firms were
funded by deposits from other venture
capital firms.
By pursuing this client-centric strategy, Silicon Valley Bank put itself in a
strong position with stable, low-cost
funding (two-thirds of its deposits were
non-interest-bearing) and balanced
growth in client assets and liabilities.
As a result, the banks share price has
performed well in the last two years,
beating the financials by 40 percent.
We are not suggesting that clientcentric strategies will necessarily
result in the advantageous balance
in assets and liabilities that Silicon
Valley Bank enjoys. For instance,
some client segments are structurally
long in financial assets. However, as
a general proposition, client-centric
strategies at the business unit level
often allow financial companies to
access their clients liquidity over time
and can drive funding requirements.

CAPITAL
MANAGEMENT

In the year leading to the onset of the

credit crisis in late 2007, the operating committee of a large, diversified, U.S.-based financial institution
repeatedly brainstormed ways to
improve top-line performance through
greater risk taking and asset growth.
However, not once during that period
was the subject of economic capital broached. Economic capital is
the financial industrys term for how
much capital (equity and long-term
debt) a bank must hold to protect its
shareholders against insolvency, given
its mix of assets and liabilities and
particular risk tolerance. At this financial institution, as in many others,
growth strategies and risk management had become largely disconnected
from capitalmanagement.
In the decade preceding the credit and
funding collapse, the focus of capital

management at most banks and

financial companies was threefold:
Meeting minimum regulatory
requirements with the lowest level
of capital possible
Leveraging common shareholders
equity with aggressive dividend/
share buy-back policies
Lowering the companys cost of
capital by optimizing its mix of
Tier One and Tier Two qualifying
debt and equity instruments
The implicit assumption was that
financial companies were sufficiently
capitalized. Capital management was
about optimization, including taking
advantage of the limitations of the
regulatory capital framework, not
about strategy.

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But that approach completely masks

what should be the true goal of
capital strategies. First and foremost,
capital strategies should broaden
the companys capital base (equity
and long-term debt) to the levels
required to protect shareholders. In
other words, the purpose of capital
strategies should be to address
the companys economic capital
requirements rather than to optimize
the use of regulatory capital.
However, most companies had little
enthusiasm for such economic capital
strategies, in part because they were
under relentless pressure to release
excess capital to boost returns on
equity and enhance short-term
valuations. In addition, quantifying
economic capital involves complex
methodologies and algorithms, and
although there have been significant
improvements in these metric tools

over the last couple of decades, many

unresolved issues remain.
We believe that the time has come to
rehabilitate economic capital and to
develop strategies that use it to its best
purpose. To achieve that, financial
companies need to take four steps:
Restore credibility to economic
capital systems. This will require
letting business judgment prevail
over the often arcane analytics
of economic capital and, in so
doing, addressing limitations in
the methodologies (in other words,
dont let the Ph.D.s run the show).
Make economic capital the
currency of risk in the
organization. That means that risk
management should not merely
set limits; more important, it
should determine the cost of risk

to the firm, with that cost being

the economic capital requirements
multiplied by the companys cost of
capital. This is essential to avoid a
repeat of the dangerous decoupling
of capital and risk management that
was evident at many companies in
the years preceding the crisis.
Incorporate economic capital
into the fabric of the company.
Integrate it into pricing decisions;
make it one of the standards
for strategic development and
performancemanagement.
At the board and senior
management levels, commit to
managing the banks capital
position to both economic capital
and regulatory requirements, not
just regulatory requirements.

Capital strategies should broaden the

companys capital base (equity and long-term
debt) to the levels required to protect
shareholders, not just satisfy the regulators.

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Key Highlights
For a long time, diversified financial
institutions had often emphasized
asset growth to the detriment of the
right side of the balance sheet.
The mix and stability of client
deposits, other liabilities, and
capital reserves (the right side of
the balance sheet) are as crucial
to a financial companys long-term
success as the quality of its loan
assets and portfolio of securities.
Funding strategies must be
implemented at both the corporate
and business unit levels.
Capital strategies involving equity
and long-term debt must focus on
growth in both economic capital
and regulatory capital, not just
regulatorycapital.

Conclusion

Because financial services is a

highly leveraged industry, balance
sheet management can never be
neglected without dire consequences.
Theevents of the last three years
have reminded us that strong funding
and capital positions are sources
of long-term competitive advantage
and value creation. And they have
clearly demonstrated that financial
institutions can ignore right-side
strategies only at their peril.

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About the Author

Gauthier Vincent is a
senior executive advisor
with Booz&Companys
financial services practice
in New York. He advises
senior management at banks
and financial companies on
corporate strategy, managing
for value, and business unit
growth strategies. Hehas 15
years of experience in financial
services as a management
consultant, an investment
banker, and a bank executive.

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